Chartered Financial Analyst Level 2
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53 The historical approach makes use of which of the following to estimate equity risk premiums (ERP)?
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A
Macroeconomic models
B
Dividend discount models
C
A government bond yield as a proxy for the risk-free rate
Explanation:
Explanation
The historical approach to estimating equity risk premiums (ERP) uses a government bond yield as a proxy for the risk-free rate.
Key Points:
- Historical Approach: This method calculates ERP by comparing the historical returns of equities with the historical returns of risk-free assets (typically government bonds).
- Government Bond Yield: Long-term government bond yields are commonly used as the risk-free rate benchmark in this calculation.
- ERP Calculation: ERP = Historical equity returns - Historical risk-free rate (government bond yield)
Why Other Options Are Incorrect:
- Macroeconomic models (A): These are used in forward-looking approaches, not historical approaches.
- Dividend discount models (B): These are used in implied ERP calculations, not historical ERP calculations.
Historical ERP Formula:
ERP = Average historical stock returns - Average historical government bond returns
ERP = Average historical stock returns - Average historical government bond returns
This approach relies on actual historical data rather than forward-looking estimates or models.
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